Strategic asset allocation plays a pivotal role in establishing the systematic risk exposures that are suitable for an investor. At Nelson Roberts, we perform strategic asset allocation using a number of different factors, which leads us to allocate assets among different classes, including domestic stocks as well as international and emerging stocks.

Allocating a portion of investments to international stocks benefits the portfolio due to the less-than-perfect correlation between international and domestic securities. In other words, when domestic stocks perform poorly, international stocks might perform relatively better, and vice versa. Diversification allows the better-performing asset class to offset some of the negative returns from the poorer-performing asset class, reducing the overall volatility, or risk, of the portfolio. In general, the lower the correlation between the domestic portfolio and international stocks, the stronger the volatility-reduction benefit achieved by adding international exposure to the portfolio. Although many agree on the benefits of diversified exposure, the question remains: how much should one allocate to international stocks?

Ideally, we want to maximize the volatility-reduction benefit achieved by adding international exposure to the portfolio, while minimizing risk. We looked at a 2014 study by Christopher Philips, CFA, of Vanguard Research, which applies historical minimum-variance analysis using data on US and non-US stocks from 1970-2013 (please contact us for more details, or to see the study). The study concludes that the maximum volatility-reduction benefit would be achieved at around 30% exposure to international stocks. However, we believe this conclusion is predicated on the relatively low average correlation calculated over that time period. When we look at historical correlation over time, we find that increased globalization over the past 20 years has dramatically increased correlations between domestic and international stocks from around 0.40 to 0.90 (see chart). We believe these correlations will remain high going forward, which would mean that the volatility-reduction benefit would be realized at lower percentage international allocation. Therefore, we generally assume a “neutral” international allocation of around 10%, which we adjust up or down based on our expectations for future returns achieved through macroeconomic analysis. We are watching closely to see if the pendulum is now set in motion away from globalization towards nationalism, which could ultimately lead to lower correlations, although that would most likely take many years.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.